Redwood Trust Inc (RWT) 2018 Q2 法說會逐字稿

Good afternoon, and welcome to the Redwood Trust Second Quarter 2018 Earnings Conference Call. (Operator Instructions)

I would now like to turn the conference over to Kristin Brown, Vice President of Investor Relations. Please go ahead.

Thank you, Vicky. Good afternoon, and thank you for joining us to review Redwood Trust second quarter 2018 earnings report.

Before we begin, I wanted to remind you that certain statements made during managements presentation with respect to future financial or business performance may constitute forward-looking statements.

Forward-looking statements are based on current expectations, forecasts and assumptions that involve risks and uncertainties that could cause actual results to differ materially.

We encourage you to read the company's annual report on Form 10-K, which provides a description of some of the factors that could have a material impact on the company's performance and can cause actual results to differ from those that may be expressed in forward-looking statements.

On this call, we will also refer to both GAAP and non-GAAP financial measures. The non-GAAP financial measures provided should not be used, utilized in isolation or considered as a substitute for measures of financial performance prepared in accordance with GAAP.

They are included to aid investors in further understanding the company's performance and to provide insight into one of the ways that management analyzes Redwood's performance.

A reconciliation between GAAP and non-GAAP financial measures is provided in both our second quarter earnings press release and our Redwood Review, which is available on our website, redwoodtrust.com.

Also note that the content of this conference call contains time-sensitive information that is accurate only as of today, Tuesday, August 7, 2018.

The company does not intend, and it undertakes no duty to update this information to reflect subsequent events or circumstances.

Finally, today's call is being recorded and will be available on the company's website later today.

I will now turn the call over to Chris Abate, Redwood's Chief Executive Officer, for opening remarks and introductions.

Thank you, and good afternoon, everyone.

Thank you for participating in Redwood's second quarter earnings call.

Joining me on the call today is Dash Robinson, Redwood's President; and Collin Cochrane, our CFO.

The second quarter marked the official start for our newly transitioned management team and my first as CEO. As many of you may recall, our high-level vision through Redwood's future growth was actually laid out back in December 2017 when the management transition was first announced.

So I'd like to start our commentary there, as many of you are likely focused on a longer-term initiatives that are now beginning to define our business.

Following our December slide presentation, we expanded on it in January, 2018, with an analysis of the secular shifts we see occurring in the housing market. Specifically, we noted an evolving view of consumers towards rentership, the increased prominence of nonbank sellers and their potential funding needs and finally, how the recently implemented tax reform legislation could change the calculus of home ownership and accelerate alternative means of real estate investing.

To address these secular shifts, we knew we needed to expand our strategic footprint across the broader housing market, with an emphasis on not only lending to traditional homebuyers but also lending to housing investors, an activity we'd like to refer to as business purpose lending.

We also noted opportunities to address the financing needs of some of our nonbank sellers, with an emphasis on strengthening our seller relationships and delivering more value to our partners throughout the mortgage life cycle.

We asserted that if we could successfully broaden our reach and recognize where our capital was most useful to the marketplace, it will lead to growing and diversified revenue streams; larger investment opportunities; greater scale and operating leverage; and ultimately, high quality and repeatable earnings.

As we evaluate the first 6 months of our long-term plan, we are happy with the progress we've made today. In addressing the secular shifts in the housing market, we partnered with 5 Arches, a business purpose lender, taking a minority stake in the company while gaining access to their single-family rental and fix and flip loan production.

Our $10 million minority investment may not have seemed overly significant at the time it was announced in the second quarter, but it is already bearing fruit. We recently began purchasing our first single-family rental loans originated through 5 Arches and have a growing pipeline of loans that we are committed to purchase.

We also committed $50 million of capital in early August to purchase short-term residential fix and flip loans, originated and managed by 5 Arches and expect that investment to generate accretive returns.

As we mentioned a few months ago, our minority stake also provides us with an exclusive option to purchase the remaining 80% of the 5 Arches platform outright over the next 9 months.

We also made good progress enhancing our strategic importance to the mortgage originators who sell us loans. Over half of these loan sellers are nonbanks and have unique funding needs to support their growth. As a leader in structured credit solutions, we can provide this portion of our sellers with unique and value-added financing that is difficult or impossible to obtain through traditional channels.

We launched our funding solutions initiative earlier this summer, flowing $40 million of capital while promoting the natural expansion of loans sourced for our mortgage conduit.

Another focus of ours has been to expand our investment portfolio through opportunities in multifamily housing credit.

We spent time cultivating relationships in this market over the past few quarters and have deployed meaningful capital towards this initiative, culminating with a significant multifamily credit investment in early August.

Capital deployed through this investment was about $55 million. We expect our multifamily credit portfolio to be a scalable and accretive source of earnings for us in future quarters.

Heading into the fall, we have additional new product initiatives underway, and we should be in a position to talk about them in detail on our next quarterly conference call.

Taken together, these new initiatives are helping to round out a multifaceted approach we are taking to scaling our platform.

But it's important to remind shareholders that we have definitely not taken our foot off the gas on our traditional mortgage banking business.

In fact, we recently completed our third Redwood Choice securitization in the third quarter and our fifth to date since we started the program in mid-2016. We also achieved a significant milestone for our overall Sequoia program, having issued our 50th post-crises Sequoia securitization this summer.

Our securitization activity in 2018 has been strong, 50 RMBS deals seemed like a distant goal when we restarted this market, with a first post-crises RMBS issuance back in 2010.

While we've had a great start to the year for residential mortgage banking, and we remain on track to achieving our annual volume targets, we acknowledge the industry-wide decline in origination activity and more challenging near-term operating environment. Dash will comment further on this during his prepared remarks.

In closing, I'd reference the first line of our shareholder letter, where we expect to signify this next era in the company's history by our commitment to profitable growth.

To keep pace with our expanding investment opportunities, we raised over $300 million from 2 accretive capital offerings in late June and July.

This included a convertible debt issuance in our first common stock offering in over 9 years. As an internally managed company, our approach to raising capital, especially common equity will continue to be in what we believe is in the long-term interest of our shareholders.

As our vision unfolds, I look forward to continuing to communicate on our strategic progress in future quarterly updates.

And with that, I'll turn the call over to Dash Robinson, Redwood's President.

Thank you, Chris. And good afternoon, everyone. I'd like to start off with our jumbo mortgage banking activity for the quarter. Despite more challenging conditions relative to the first quarter, we successfully completed 4 Sequoia securitizations on loans totaling over $1.7 billion and increased our purchase volume to approximately $2 billion, up [8%] from the prior quarter and 60% from the second quarter of 2017. These growth metrics underscore the overall trajectory of our mortgage banking business and further validate the benefits of channel diversification through efforts such as Redwood Choice.

Through the end of the second quarter, our purchase total for 2018 was $3.75 billion, on track to meet our full year volume guidance of $7 billion to $8 billion.

Overall, mortgage banking generated margins that were within our long-term expected range of 75 to 100 basis points versus the outsized margins we realized in the first quarter.

The uptick in rates, as it often does, has caused originators to assess near-term operational capacity and margin requirements, given changes in their production mix. Additionally, and as expected, based on pricing dynamics we saw earlier in the year, jumbo RMBS issuance in the second quarter increased, causing spreads to soften somewhat heading into quarter-end.

Notably, we have recently seen spreads begin to firm and retrace some of this widening. The nature of our pipeline in the second quarter reflected the overall market trend of heavier purchase money volume, 73% of our volume represented purchase money transactions versus 63% in the first quarter and 64% for full year 2017.

In our view, the current environment reaffirms the value of product diversity that we bring to our sellers, most notably, Redwood Choice.

This channel remains a significant area of growth for us, with choice loans accounting for approximately 33% of our total second quarter lock volume, up from 29% in the first quarter.

Through the first half of 2018, we have purchased $1.2 billion of choice loans, on track to meet our full year goal of $2.5 billion.

As Chris mentioned, so far in the third quarter, we have completed our third expanded prime choice securitization of the year, our fifth since the program's inception.

We were pleased with the execution on this transaction and expect to complete additional Sequoia transactions later in the quarter.

Additionally, we remain active in selling whole loan pools, which comprise 14% of our total distribution in the second quarter.

Even when securitization execution is particularly strong, as it has often been in the last several quarters, we maintain the discipline of keeping our whole loan sale channels open and active.

Turning to our investment portfolio. The second quarter was a strong one for capital deployment. Overall, in the second quarter, we deployed $186 million of capital into both new and existing initiatives.

Over 40% of the quarter's activity was inorganically created investments, including Sequoia bonds and our minority investment in 5 Arches. This momentum has carried over into the third quarter, and we have been actively putting our freshly raised capital to work.

Since quarter-end, we have deployed approximately $140 million of capital, including the multifamily and fix and flip investments Chris described.

Additionally, we remained active in optimizing our capital allocations in the second quarter as we continue to rotate out of lower-yielding and less-strategic assets.

Specifically, we freed up approximately $91 million of capital for redeployment during the second quarter, capturing $12 million of previously unrealized gains.

I'll conclude with the progress report on our single-family rental efforts with 5 Arches as we are off to a strong start. We recently funded our first single-family rental loan and have a robust pipeline growing for a suite of bars nationwide.

Overall, we continue to observe secular trends in the market, driving demand for nonowner-occupied housing and believe financing needs in this sector are being inefficiently served.

Our partnership with 5 Arches positions us well to be a solutions provider to several areas within business-purposed real estate lending. And we believe the integration of these new loan types with our platform will drive additional scale and make us an even more valuable partner to our existing seller network.

Now, to recap our financial results, I'm going to turn it over to Collin Cochrane, Redwood's Chief Financial Officer.

Thanks, Dash. And good afternoon, everyone. To summarize our financial results for the second quarter, our GAAP earnings were $0.38 per share compared with $0.50 in the first quarter, and core earnings were $0.41 per share compared with $0.60 in the first quarter. Our second quarter results reflect lower mortgage banking income, with gross margins within our long-term expected range after outperformance in the first quarter.

Additionally, we experienced a decrease in gains realized from security sales relative to the first quarter as the pace of our portfolio optimization moderated.

Our GAAP book value increased $0.11 to $16.23 per share at June 30, which, with our new quarterly dividend rate of $0.30 per share, generated a total economic return of 2.5% for the quarter.

Our solid earnings and an increase in the value of the derivatives hedging our long-term debt primarily contributed to this increase.

As we've noted previously, our investment and hedging strategy makes our portfolio less sensitive to changes in interest rates, and our book value is minimally impacted by rising rates during the quarter.

On a hedge-adjusted basis, we saw a slight overall benefit from fair value changes during the second quarter, driven mostly by modest improvements in CRT and multifamily spreads.

Net interest income for investment portfolio decreased slightly from the first quarter due to higher interest expense, though this decrease was more than offset by a benefit of $3 million and reduced net swap interest expense on our associated hedges, which is included in our investment fair value changes line item.

On a combined basis, net interest income and net swap interest expense increased by $3 million from the first quarter, representing the benefit from increased capital deployment and higher yields from recent portfolio optimization.

Shifting to the taxable side for a moment. Our total taxable income was $0.51 per share for the second quarter, a decrease from the first quarter, reflecting fewer gains from portfolio optimization at the REIT and lower mortgage banking income at our TRS. Year-to-date, retaxable income has exceeded our dividends, primarily due to capital gains, which will result in a portion of our dividend being characterized as long-term capital gain and likely require us to utilize a portion of our $57 million net operating loss carryforward at the REIT.

Turning to the balance sheet and our capital position, we recently raised approximately $317 million of capital, including our $200 million of convertible debt in June and $117 million of equity in July. Additionally, in April, we repaid $250 million of convertible debt upon its maturity. We ended the quarter with about $200 million of capital available for investment and with the proceeds from the equity issuance, that brought the total to a bit over $300 million.

As Dash mentioned, we are already off to a good start putting this new capital to work.

Regarding leverage, our recourse debt to equity leverage ratio remained at 3.4x at the end of the second quarter. And while the equity raise in July reduced our leverage from this level, we expect leverage will begin to tick back up as the new capital is deployed.

I'll close with our 2018 financial outlook. In summary, our year-to-date results are on track to exceed our expected dividend payments of $1.18 per share, and we also remain on track to meet the full year operational targets we provided in our fourth quarter Redwood Review.

Specifically, for our mortgage banking business, we remain on track to meet our full year expectations of purchasing $7 billion to $8 billion of jumbo loans and doubling our choice purchase volume for 2017, with margins within our expected range of 75 to 100 basis points and generating a return on allocated capital between 10% and 20%.

For investment portfolio, we continue to expect full year returns on allocated capital in line with our expectations of 9% to 11%.

And finally, we continue to expect full year corporate operating expenses between $40 million and $45 million, with variable compensation commensurate with company performance.

And with that, I'll conclude our prepared remarks. Operator, why don't we start the Q&A?

(Operator Instructions) We'll go first to Vik Agarwal with Compass Point.

I want to start with maybe a little bit on the competitive environment. When do you think the -- or how are you kind of thinking about the excess capacity in the system? And how long do you think that it'll potentially take to come out? And does that mean that we could potentially expect your gain on sale to be slightly higher than your long-term averages at that point?

As far as capacity goes, it's something that, I'm sure, most on this call have heard about at this point, there is excess capacity out there. I don't think the second quarter was going to be the quarter for rationalization, it includes the spring selling season, and historically, from a seasonal perspective, it's a very busy quarter. So you could see this continue for a period of time, perhaps later in the fall or in the fourth quarter, we'll start to see some rationalization. But we think it needs to occur, it's a cyclical business, this happens routinely in the mortgage business. The key to us is our positioning, number one, and number two, our balance sheet. As you know, Redwood has a very strong balance sheet and just given the niche products and the specialty aspect of what we do, we feel like we'll be able to take advantage of some rationalization. From a margin perspective, [we always love] to provide any guidance outside of our long-term expectations. We had significant margins in the first quarter, when we caution then against drawing a line through them, we think that spreads have compressed, certainly, in the past few months, but we'd also cautioned against drawing a line through those. I think in the long run, once capacity is corrected, that 75 to 100 basis points is where we expect to make money in the business.

Okay. And I think my next question has come up on a few times or been discussed a couple of times. But now that we have, potentially, the FHFA Director term expiring in January, any potential thoughts there in terms of private capital risk sharing? Or is it still a little early to have that discussion?

It's still a little early, certainly because the successor to Mel Watt, if there is one in January, is TBD. We do think it has the potential for meaningful, positive benefits to the private market. Certainly, with respect to GSE reform but also with the potential to revisit our home loan bank membership status, which is also something we're very focused on in Washington these days.

And lastly, I think you mentioned that you've deployed -- or you're about to deploy $50 million in capital for 5 Arches production. How should we think about that for the remainder of the year? Or is that the allocation for the remainder of the year at this point?

Vik, it's Dash. I'll take that one. I would think about the 5 Arch capital deployment in a couple of different pieces. The $50 million that Chris talked to during the prepared remarks is in the shorter term, more rehab and resale or fix and flip product. And so we put some capital to work earlier this month and also concurrently entered into a flow purchase agreement to purchase a portion of that particular type of production from 5 Arches. So we expect that capital deployment at least for now to be maintained at that level. Separately, and what we've been working on for quite some time, as you know, is the single-family rental piece. And we've started to deploy capital there. And like we've said, our hope is, by the end of the year, we'll be purchasing those loans at sort of a $50 million to $60 million a month clip. And we'll have leveraged on top of that, so that won't be our monthly capital deployment by the end of the year. But that gives you a sense of how we hope that the pipeline -- to scale over time. So as I said, we have a pipeline building, we purchased our first couple of single-family rental loans, and by the end of the year, that's the clip in which we hope to be deploying monthly into that asset class, so it's the sum of those 2 parts when you think about the 5 Arches partnership.

We'll go next to Steve Delaney with JMP Securities.

I wanted to ask about the access of core over GAAP, we don't usually see that. And Collin, I guess I'll address this to you, but the phrase in that sentence is gains realized versus sale trading securities. Is it simply a situation where, in prior periods, you had unrealized gains that were in GAAP, and now that those securities have actually been sold, you are simply converting that unrealized gain to a realized gain and including that in your core?

Yes. You have that right. So the trading securities, we do mark them to market through the P&L, so they go through GAAP earnings. But we back those marks out to get to core earnings. And so when we ultimately sell those trading securities and realize those gains, at that point in time, we take the benefit through cores. So that's what you're seeing there.

Got it. So -- and of course, on trading -- I'm sorry, go ahead, Dash or Chris.

That was me. I was just confirming, it's the gain on -- the realized gain on the trading securities.

Okay, great. And the trading securities, that's fair value marked through the income statement versus OCI anyway, I assume. But exactly what type of securities do you classify as trading?

At this point, about 3 quarters of our portfolio is classified as trading. A long time ago, a lot of our portfolio was available for sale, but now predominantly, most of our securities are trading, some of our first-class credit pieces that we retain through our Sequoias are available for sale and then some of our legacy securities that we still have back from several years ago are still under the AFS designation.

Okay. Dash, I guess, this is for you. On the customized warehouse program, I think you first mentioned that on your last call, but it's now effective $40 million. Can you talk a little bit about -- we, obviously -- we know what warehouse lines are, everybody needs them. What is the unique thing that these nonbank correspondents -- what is it that they need that you're providing that's [stealing] a hole in the marketplace?

Sure. Thanks for the question, Steve. At a high level, the notion of that strategy is broader than specifically warehouse line. The idea is to work with our sellers and adjust our balance sheet to provide more sort of rifle-shot, customized working capital needs that can help them run their business more efficiently. One example of that is the warehouse structure where we are effectively adding on a couple of points of additional leverage on top of an existing banks' warehouse line. And that, the economic effect that, that has is allowing the sellers to recycle their capital more efficiently, it's a little bit of the economic equivalent of us buying the loans sooner but preserving a security package that we think is compelling, including leveraging the operations aspect as well as having cross collateralization with the loans and of course, recourse in the warehouse structure to the borrowers. So we're not building a warehouse business, we're leveraging our partnerships to provide that sort of working capital.

On that piece, what I would add is, the real initiative is how do we deliver more value to our sellers. Financing is one aspect, product is another aspect, time to close, time to fund. We think about all these things and ultimately, we feel like if we're more engaged to better partner, it's going to result in good things for Redwood. Another nuance here is because we have a vast network and because we already do so much work on the counterparty risk front, we're able to do these things relatively efficiently. This is not necessarily the type of business activity that we would jump into without the network that we have. But with years of experience with these sellers, understanding their financials and the associated risks and sitting across the table from the management teams, we've been able to get comfort launching this type of initiative.

That's the -- it's the life blood of your business. I mean, your alternative is to try to go out and build your own national origination platform, and those situations kind of embattle you a lot of times, right? I mean, so this is a way of being more of a strategic, financial partner rather than adding new stores and all the bricks and mortar, et cetera. So it sounds like -- look, you're adding the add-on to the warehouse advance. You're simply prefunding -- you're going to buy the loan anyway, right? So you're going to pay 100 cent on the dollar, so if you just tack on a little bit beyond what the bank is comfortable advancing, that's all going to settle out when you take the loan in. It sounds like the strategic part of this is that you are actually sitting down and looking at their businesses and being a more of a like a senior term lender to them -- to their business, if you will, as opposed to just financing the warehouse line. Am I reading that right?

I think that's really the essence of it, Steve. To Chris' point, from partner to partner, the nature of the capital deployed will differ. If there's capital deployed, it could be product customization and in other ways, to just make ourselves more strategically important to our seller. It's all of the above, this is one example of that, Choice is another and all of our product innovation and creative partnership to get the hard loans done and fund more efficiently and reliably than others. All these activities are really in that [album], in that genre. It's all working towards the same goal, to your point of deepening the partnership with our sellers and also growing the business with them.

We'll go next to Bose George with KBW.

Can you just talk about a good way to -- Chris, think about the timeline for deploying the capital that you guys increased?

Yes. I mean, I think, as Dash mentioned, we really got off to a strong start here in the beginning of the third quarter with about $140 million already lined up to get deployed. I think as we look forward for the rest of the year, it's hard to exactly pin down a number for Q3 or Q4. But we feel like we're off to a strong start and a good pace. I think we mentioned in the review, it will take some time to get that capital out the door. So we mentioned there could be some slight dilution in the very near term as that gets out. But if we can keep it pace up that we're seeing early on here, we could get that out here potentially by the end of the year. And there's just a lot of variables there to consider.

This is Dash. One thing I would add. What's nice about the deployment since quarter to date, is that it has been chunky, it's been more structured transactions where we've leveraged our partnerships and our structuring creativity to stores, assets that we feel like others can easily replicate. And so we're thrilled with the $140 million, but we're also thrilled with the composition of the $140 million because it's unique, and that will obviously help us build towards deploying this capital more efficiently and quickly, in addition to our regular investing activities. So it's the number, but also, it's the composition of the investment that we're excited about.

Okay, great. That makes sense. Actually, just in terms of leverage on the new asset classes that you're in. Is it going to look sort of similar? Will the rent leverage sort of end up being roughly the similar once your capital is fully deployed?

Just to clarify, you're speaking specifically to the business purpose loan products?

Yes. The business purpose loan, yes, the single family, all that stuff, yes.

Yes. Leverage, I think, will be a little bit lower if you look at how we'll finance those loans on warehouse lines. The haircut will be a little bit fatter than how we run our jumbo business currently. And then, of course, when we securitize, one of the things that's appealing about it, particularly for single-family rental is that the amount of the capital structure [we'll] take back, we expect to be larger in both our Select and Choice programs. Choice, we talked about before, is typically 3 to 4x Select and we expect the single-family rental deployment to be in excess of Choice. So they're newer asset classes, leverage is certainly available, but it will be less leverage slightly then how we typically aggregate and then securitize our jumbo loans.

Okay. And then, actually, just any updated thoughts on the multi -- the Freddie Mac multifamily program, whether you want to do more there in the BP side?

Yes. And that continues to be a strategic priority for us. We have deployed a lot of human resources towards that effort and an increasing amount of capital. So that's definitely front and center for us, we're optimistic about the supply in the second half of the year, and I would expect us to be increasingly active in that market.

There are no further questions at this time. I would now like to turn the call back to Chris Abate for closing remarks.

Okay. We very much appreciate you taking the time today to participate on the earnings call. We feel confident about our Redwood's position in the market and remain bullish on our prospects for the future. Thank you very much.

That does conclude today's conference. We thank you for your participation.